Financial Decision

Making and Law of

One Price

Chapters 3, 4, and sections 5.1, 5.2, 5.5

Learning objectives (1/2)

• Competitive market prices determine value

• Analyze costs and benefits of financial decisions

• Interest rates and opportunity costs: the time value of

money

• Compare values at different points in time

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Learning objectives (2/2)

• Calculate the present value of:

• A single sum, a stream of cash flows

• An infinite stream of regular cash flows (perpetuities)

• A stream of regular cash flows with regular frequency (annuities)

• Real-life applications: work out a costs of a residential

loan

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Intro: decision making (1/5)
• Decision making is an algorithm, which:

• Involves alternatives (to buy or not to buy)

• Involves costs and benefits of alternatives

• Involves some rule by which we define/quantify the costs and benefits

• We make decisions when the value of benefits exceeds that of costs

• The real question is “What is value?”

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Intro: an old-time problem: what
is value? (2/5)
• Economists have been fighting with the concept of
«value» for centuries: what is the value of a commodity?

• Some of you like history???

• Luckily (for those who do not like history) we just need to

understand what determines value in modern finance
theory

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Intro: what is value in modern
finance (3/5)
• You just won a lottery. The prize is two tickets to a concert of Charlotte
Gainsbourg at «Les Nuits de Fourvière» (face value €39 each).

• You are not a big fan of her, but you would rather go to the sold-out show of
Massive Attacks, whose ticket costs €75 on eBay. What would you do?

• Your personal preferences do not really matter for the «value» of the tickets
you won

• Check the price of Gainsbourg’ tickets on eBay, sell them there, and with the
proceeds buy one ticket for Massive Attacks

• Value = eBay (competitive) price

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Intro: decision making (4/5)

• Decisions about buying/selling products are made on

product markets (Buy a laptop or not? Buy a Mac or a PC?)

• The values of costs are easily observable, they are the market prices of
each product

• The benefits are harder to obtain, they may be personal attitudes

towards products (preference for Massive Attacks), but also profits,
efficiency gains etc.

• Decision: exchange money today (cost) for a product

(benefit) today
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Intro: decision making (5/5)
• Financial “products” are different from usual ones: they are asynchronous:

• We pay some price today (costs) while the “product” (e.g. a bond) delivers the
benefit (some fixed amount of money) in the future

• Financial market is an instance (or some place) where we exchange /

transact money today for money from the future

• This can be informal (friend’s loan…) or formal (stock or bond exchange)

• Accordingly, to make decisions we need to relate the costs and benefits that
occur at different points in time!

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Notations
• The timelines (always draw)

• Periods are of equal length (at least in this course), cash flows occur at the end

• Cash flows are positive or negative depending on the perspective

• From my perspective, a €100 bill that I pay to someone is a negative cash flow

• From that someone’s perspective that same €100 bill is a positive cash flow

• Interpretation: we can express this in different wordings, e.g. borrow/lend,

invest/realize returns, buy cash from the future with the cash today, etc.

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Own pocket vs. bank account

• Suppose we save $100 at the bank and the bank

offers $110 one year from now:
Today Year 1
Our
pocket
-$100.00 $110.00 Note how this
corresponds to the
10% of
Today Year 1 - Interest or
Bank - Return ☺

$100.00 -$110.00

Why should there be an interest / return?

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Why should there be an interest
(return)?
• Suppose there is none; hence we receive $100 at the end of the year

• Why should you wait one year to spend $100?

• What if prices increase over time (aka inflation)?

• What if the payoff is uncertain?

• The interest (return) is there to motivate us to enter this kind of transactions!

• But how do we know if the price we paid (return / interest we earned) is fair?

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Interest and opportunity cost
• The Law of One price: In competitive markets, two similar products must
trade at the same price!

• In which bank do we save (which investment do we make)?

Interest or
Today Year 1 Return
Bank A Banks
Depositors -$91.00 $100.00 9.89% compete for
compete for
Today Year 1 depositors’
payoffs!
Bank B money!
-$90.00 $100.00 11.11%

• The interest (return) and the price of [future] money are two sides of the
same coin

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Interest and opportunity cost
• What we loose by making a choice is called the opportunity cost

• Choosing bank A means we loose a chance to earn 11.11%

• Choosing bank A (R = 9.89%) over B (R = 11.11%) is the same as paying $91 for the same
$100 instead of paying $90!

• As such, all of us will want to save with B and “force” bank A to change its
policy or go out of business – this is competitive market!

• We thus impose our opportunity cost on bank A’s promise!

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Opportunity cost: bottom line
• Bank A can make us indifferent (and stay in business) by:

• Reducing the price (to $90) or

• Increasing the final payoff without a change in initial price

• Both possibilities mean “increase the interest promised by A”!

• What we want is the greatest possible return (or the lowest possible price)

• We usually work with returns (they do not depend on sizes of cash flows)

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Savings example (1/2)
• Present value (PV) is today’s value (amount) of cash; Future value (FV) is
future value (amount) of cash

• Suppose we save $1000 in a bank over one year; the competitive interest
rate (opportunity cost) is 10%

𝐹𝑉 = 𝑃𝑉 × 1 + Interest rate

$1100 = $1000 × (1 + 10%)

Present value Future value

• The interest rate provides for a rate at which we exchange money today for
money in the future (1.10 here)
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Savings example (2/2)
• What happens if we want to save for more than a year?

• If we put $1000 at the savings account today, how much will we have in two
years?

FV = PV × 1 + Interest rate × 1 + Interest rate = 𝑃𝑉 × (1 + Interest rate)2

2
$1210 = $1000 × 1 + 10% = $1210

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Mechanics of the interest rate

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Choice example

• Suppose you have a choice between receiving

$5,000 (A) today or $10,000 (B) in five years

• You believe you can earn r = 10% on the $5,000

today, but want to know what the $5,000 will be
worth in five years

• Note that r = 10% is the opportunity cost!

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Explanation
0 1 2 3 4 5

$5,000 x 1.10 $5, 500 x 1.10 $6,050 x 1.10 $6,655 x 1.10 $7,321 x 1.10 $8,053

• In five years, the $5,000 will grow to:

FV = PV × 1 + 𝑟 5 = $5,000 × 1 + 10% 5 = $8,053

• Thus, you would be better off forgoing the gift of $5,000 (A) today and
taking the $10,000 (B) in five years

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Reverse the order
Compound
0 1 2 3 4 5

$5,000 x 1.10 $5, 500 x 1.10 $6,050 x 1.10 $6,655 x 1.10 $7,321 x 1.10 $8,053
Present value Future value
Discount

• We computed the future value (FV) but reversing the computation obtains us
the present value (PV)

• The key ingredient to relate the PV to the FV is the appropriate opportunity

cost (discount / compound rate)

𝐹𝑉 $8,053
𝑃𝑉 = $5,000 = 5
= 5
1+𝑟 1 + 10%
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Applying the opportunity cost
• Remember that we computed the FV of the $5,000 by moving it to the future
(compounding)

• We established that $5,000 today is less valuable than $10,000 in 5 years

given 10% opportunity cost rate

• We can also compute how much money would we need to save today to get
10,000 in year 5 (the present value of $10,000)
𝐹𝑉 $10,000
𝑃𝑉 = 5
= 5
= $6,209.21
1+𝑟 1 + 10%

• Thus, the today’s equivalent of $10,000 in year 5 is $6,209.21

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Applying the opportunity cost

Today Year 5
Choice A
Get: Equivalent:
$5,000.00 $8,052.55

Today Year 5
Choice B
Equivalent: Get:
$6,209.21 $10,000.00

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Applying the opportunity cost

• We do not care if we have $5,000 now or $8,053 in year

5 (they are equivalent)

• We do not care if we have $6,209.21 now or $10,000 in

year 5 (they are equivalent)

• But we do care to have more than less now (so we prefer

$6,209.21 to $5,000)

• And we do care to have more than less in year 5 (so we

prefer $10,000 to $8,053)
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Three Rules of Time Travel
• Financial decisions often require combining cash flows or comparing
values

• Three rules govern these processes

• Discount and compound rates reflect our opportunity cost

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Exercise: a zero-coupon bond

A. $7,903.05

B. $8,375.92

C. $8,457.29

D. $8,745.22

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Solution: B

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Exercise: saving for old age
• You are 20 years old and are considering putting €100 into an
account paying 3% per year for 45 years. How much will you have in
the account at age 65? How much of it will be simple interest, and
how much compound interest (approx. to the nearest €)?

• €258; €135; €123

• €378; €135; €143

• €319; €135; €184

• €345; €120; €225

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Solution: B

• Using the FV formula:

• FV = €100 x (1.03)45 = €378.16

• The total interest earned is €378 – €100 = €278,

and the simple interest is 45 x 0.03 x 100 =
€135, the rest €278 – €135 = €143 is the
compound interest

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A stream of cash flows
• Recall the 1st rule: It is only possible to compare or combine values
at the same point in time

• So far, we have looked at one-time cash flows

• But suppose we plan to save $1000 today, and $1000 at the end of
each of the next two years

• If we can earn a fixed 10% interest rate on our savings, how much
will we have three years from today?

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Always draw the timeline
• This time the timeline will look like this:

• If we apply the compounding to the first cash flow once we get:

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Sequential solution

• Moving forward and combine with other CFs

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Compounding of single cash
flows
• Moving all cash flows forward separately gives:

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We can also solve this
differently…

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Valuing a stream of cash flows

𝑁 𝑁
𝐶𝑛
𝑃𝑉 = ෍ 𝑃𝑉(𝐶𝑛 ) = ෍ 𝑛
1+𝑟
𝑛=1 𝑛=1

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Exercise: withdraw money
• You have a bank account. Suppose you want to withdraw $1,000
one year from now, and $3,000 in two years. If the interest rate you
earn on the account is 10% per year, how much do you have to put
into that account today in order to satisfy these requirements?

• $2,875.72

• $3,234.15

• $3,561.98

• $3,388.43

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Solution: D

• Just compute the PV of the two required

payments using a 10% interest rate:

• PV = $1,000/(1.10)1 + $3,000/(1.10)2 =
$3,388.43

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Exercise: buy a shop
• You are thinking of buying a shop that generates the following cash
flows: $25,000 one year from now, $20,000 two years from now and
$15,000 three years from now. Suppose you can invest your money
in a safe account earning an interest rate of 5% per year. How much
would you be willing to pay the shop at most?

• $52,967.32

• $54,097.87

• $54,907,68

• $55,077.73
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Solution: C

• You will never agree to pay more than the PV of these

future cash flows when you discount them at 5%: indeed,
if you pay more, you would lose money overall, since you
know you can earn 5% investing your initial amount on an
alternative, safe investment.

• PV = $25,000/(1.05)1 + $20,000/(1.05)2 +
$15,000/(1.05)3 = $54,907,68

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NPV decision rule
• NPV = PV(Benefits) – PV(Costs)

• Simple! But… look at the next examples

• Your firm is offered the following investment opportunity: in exchange for

€500 today, you will receive €550 in a year with certainty. The risk-free
interest rate at which you can lend and borrow money is 8%

• There is no cash available in your firm at this moment. What would you do?

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NPV decision rule
• PV(Benefit) = €550/(1.08) = €509.26

• PV(Cost) = €500 → NPV = €9.26 > 0

• Take a loan @ 8%: +€509.26 today

• Invest €500 → today you earn €9.26

• In one year you obtain €550 from the opportunity and reimburse the loan = €509.26 X
(1.08) = €550!

• So long as the NPV > 0 the opportunity creates value (=profits)

• NPV = cash today

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NPV decision rule
• Few years ago you started a Web site hosting business and now you have decided to
return to return to school to take a Master degree. An investor offers you to buy the
business for €200,000 whenever you are ready. You can lend and borrow money at
10% per year. Today, you also need €60,000 to pay for the school and other
expenses. Which of the following alternatives is the best choice?

• Sell the business now;

• Scale back the business and continue running it while you are in school for one more year,
then sell it in a year. In this case, you need to spend 30,000EUR on expenses now, but
generating €50,000 in profit at the end of this year;

• Hire someone to manage the business while you are in school for one more year, then sell
the business. In this case, you need to spend €50,000 on expenses now, but generating
€100,000 in profit at the end of this year.

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NPV decision rule
• NPV(Sell now) = €200,000

• NPV(Scale Back) = −30,000 + (50,000 + 200,000)/1.10 = €197,273

• NPV(Manager) = −50,000 + (100,000 + 200,000)/1.10 = €222,727

• Ok: but what about the €60,000 you need for the school?

• Borrow €110,000 today to hire the manager and pay the school. You will need to
reimburse €121,000 in a year → cash flow in a year = €179,000 (200k + 100k −
121k)

• If you sell now, you can reinvest €140,000 (net of the payment for the school) →
€154,000 in a year

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Time value of money: real world
applications
• Personal finance real-life decisions where time value of money plays
a key role:

• Saving money for future use (consumption, retirement, personal

investment,…)

• Borrowing money (for current consumption, investment, …)

• Firms’ real-life decisions:

• Investment analysis

• Capital budgeting

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Standardized cash flow streams

• We see financial opportunities in terms of cash

flow streams

• Many applications involve 4 standardized cash

flow streams

• Constant perpetuity (1) and (2) annuity

• Growing perpetuity (3) and (4) annuity

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(1) Constant perpetuity

• When a constant cash flow will occur at regular

intervals forever it is called a perpetuity

• Present Value of a Perpetuity:

C
PV (C in perpetuity) =
r

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Example of perpetuity: an
academic chair
• You want to endow a chair for a female professor of
finance at your alma mater. You’d like to attract a
prestigious faculty member, so you’d like the endowment
to add $100,000 per year to the faculty member’s
resources (salary, travel, databases, etc.)

• If you expect to earn a rate of return of 4% annually on

the endowment, how much will you need to donate to
fund the chair?

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Perpetuity: an academic chair
• The timeline of the cash flows looks like this:

• This is a perpetuity of $100,000 per year. The funding you would

need to give is the present value of that perpetuity

• Solution (apply the previous formula): you would need to donate $2.5
million to endow the chair

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(2) Constant annuity
• When a constant cash flow will occur at regular intervals for a finite
number of N periods, it is called an annuity

• Present Value of an Annuity:

C C C C N C
PV = + + + ... + = 
( 1 + r ) ( 1 + r )2 ( 1 + r )3 ( 1 + r )N n=1 ( 1 + r )n

C 1 
PV (annuity; C , r , n) = 1 − 
n 
r  (1 + r ) 
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Example of annuity: a retirement
rent
• You are 65 years old and are considering whether it pays to buy an
annuity from an insurance company. For a cost of $100,000 the
insurance company will pay you $10,000 per year for the rest of your
life, starting next year. You can earn 8% per year investing your
money in a bank account and you expect to live until age 80.

• Is it worth for you to buy the annuity? The implied interest rate the
insurance company is paying you is higher or lower than 8%?

• A. No; is lower C. Yes; is lower

• B. No; is higher D. Yes; is higher

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Annuity: a retirement rent
• The annuity is expected to make 15 payments of $10,000 each, and the PV
of these payments at a discount of 8% per year is:

• PV = (10,000/0.08) x [1 – 1/(1+0.08)15] = $85,594.79

• This is lower than $100,000; it is not worth to buy this annuity (you overpay)

• Asking you to pay $100,000 for this product, the insurance company is
offering the rate that makes the PV of such an annuity equal to $100,000:
since PV and rate are inversely related, the insurance company is then
paying you implicitly a rate which is lower than 8%

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Example: mortgage payment

• You have just decided to buy a house and you need to

borrow $150,000.

• One bank offers you a mortgage loan to be repaid over

20 years in 240 monthly repayments

• The interest rate is 1% per month. How much do you

have to repay monthly to reimburse such a loan?

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Mortgage payment
• Use the formula that computes the PV of an annuity with n = 240
repayments and r = 1%. You know that the PV must be equal to
$150,000 and you solve for the monthly payment:

• PV = (C/r) * (1 – 1/(1+r)n)

• C = (0.01*PV) / (1 – 1/(1.01)240)

• C = (0.01*150,000) / (1 – 1/(1.01)240) = $1,651.63

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Exercise: delayed annuity

• You will receive a four-year annuity of $300 per-year,

beginning at date 6. If the interest rate is 10%, what is the
present value of this annuity?

• $484.94

• $502.14

• $590.48

• $635.67

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Solution: C

• Pay attention that the annuity starts at period 6. We can

first compute the value of this annuity at date 5, using the
formula

• PV(@5) = (C/r) * (1 – 1/(1+r)n)

• with C = 300, r = 10% and n = 4: PV(@5) = $950.96

• And then discount this amount back to date zero:

• 950.96 / (1.10)5 = $590.48

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(3) Growing perpetuity

• Assume you expect the amount of your perpetual

payment to increase at a constant rate, g

• Present Value of a Growing Perpetuity

C
PV (growing perpetuity) =
r − g

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Example of growing perpetuity:
accounting for inflation
• Recall the example of an academic chair

• $2.5m had to be donated (at 4%) to generate $100k per year to

cover for the expenses of the academic chair

• Suppose that we want to increase the annual cash flow by 2%

forever starting year 2 (to account for the inflation)

• The timeline will now look different:

$100k $100k × (1+2%) $100k × (1+2%)2 $100k × (1+2%)3

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Growing perpetuity: accounting
for inflation
• Using the formula we can immediately compute the
present value of this perpetual stream

𝐶 $100𝑘 $100𝑘
𝑃𝑉 = = = = $5𝑚
𝑟 − 𝑔 4% − 2% 0.02

• We must double the donation to account for the 2%

growth rate

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(4) Growing annuity

• The present value of a growing annuity expiring

after N periods with initial cash flow C, growth
rate g, and interest rate r is defined as:

1   1 + g  
N

PV = C  1 −   
(r − g )   (1 + r )  

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Solving for variables other than
PV or FV
• Sometimes we know the present value or future value, but do not
know one of the variables we have previously been given as an input
(e.g. C, g).

• Some important examples:

• When you take out a loan you may know the amount you would like to
borrow, but may not know the loan payments that will be required to
repay it

• You want to achieve a certain wealth at the moment of your retirement,

but you do not know how much you need to save every year to reach it

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Example of a loan annual
payment

• From the annuity formula we can solve this directly:

P 80,000
C= = = 7,106.19
1 1  1  1 
1 −  1 − 
30 
r  (1 + r ) N  0.08  (1 + 0.08) 

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Payments frequency and the
effective annual rates (EAR)
• In this example we pay the annuities once a year

• What would change if the loan payments were not annual

but monthly?

• Intuitively we could guess that the monthly payment

should be: $7,106 / 12 = $592

• But… it’s not

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Payments frequency and the
effective annual rates (EAR)
• All the formulas we have seen so far work for whatever time
frequency we use for t (year, month, day…), provided we are
internally consistent

• Let us start by giving a name to r when t is measured in years:

• The Effective Annual Rate (EAR)

• Indicates the total amount of interest that will be earned (or paid) at the
end of one year

• The loan in the previous example has the EAR of 8%

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Interest rate quotes and
adjustments
• However, earning an 8% return annually is not the same
as earning 4% every six months (why?)

• General Equation for Discount Rate Period Conversion

Equivalent n-Period Discount Rate = (1 + r ) n − 1

• (1.08)0.5 – 1= 1.0392 – 1 = 3.92%

• Note: n = 0.5 since we are solving for the six month

(or 1/2 year) rate

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Timelines with non-annual
frequency
• We may represent a $80,000, 30-year, loan with 8% EAR and
monthly payments as a timeline with N = 30 x 12 = 360 equal
installments such that:
80,000
C=
1 1 
1 − 
360 
r  (1 + r ) 
• The problem is: what is the appropriate r now?

• Using the General Equation for Discount Rate Period Conversion:

(1 + 8%)(1/12) – 1= 1.00643 – 1 = 0.643%

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Computing the monthly
payment
• Using the annuity formula we now find:
80,000
C= = $571.25
1  1 
1 − 
360 
0.643%  (1 + 0.643% ) 

• Which is less than our naïve expectation of $7,106 / 12 =

$592

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The outstanding loan balance
• We use the same example of buying the warehouse for $100,000
taking a loan of $80,000

• Suppose now that after 15 years the firm sells the warehouse for
$120,000

• When selling the asset, the loan must be paid back to the bank

• How much do you still owe to the bank after 15 of the 30 years of the
loan?

• Naïve estimate: 80,000 / 2 = 40,000, but, again… it’s not!

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The outstanding loan balance

• The amount of money you still owe to the bank is

known as the outstanding loan balance

• It is the present value of the payments you still

have to make

• In other terms, for both you and the bank it is the

fair amount of money which “clears” the
relationship
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Computing the outstanding loan
balance
• In our example, the outstanding loan balance is given by
the PV of the annuity with coupon payment = 7,106 at
8% EAR, that you still have to pay for 15 years

7,106  1 
Outstanding Loan Balance = 1 −  = $60,824
15 
8%  (1 + 8% ) 

• Why is it more than 40,000?

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Interest and principal repayment

• Whenever the payment of the loan exceeds the interest

due on the outstanding balance, the “excess payment”
constitutes a repayment of the principal

• E.g. for a $80,000 loan with EAR = 8% and annual payments, in

the first year you would pay: 8% x $80,000 = $6,400 of interests

• But the annual payment is $7,106 → the difference of $7,106 −

$6,400 = $706 is a first repayment of the principal ($80,000) of
the loan

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Interest and principal repayment
• The following year the initial outstanding balance will be $80,000 –
$706 = $79,294

• Interests due will be: $79,294 x 8% = $6,343.5

• The remaining portion of the payment will thus be a repayment of the

principal equal to:

• $7,106 – $6,343.5 = $762.5

• While the annual payment stays constant, its composition varies,

with more and more principal repayment, as shown in the next slide

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Interest, repayments and
outstanding loan balance
Annual payment

Loan balance
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Business examples of such
loans
• Leasing / acquisition of aircrafts by airline
companies

• Acquisitions of large real estate / property

• Amortizable LBO loans

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Takeaways

• Financial decision-making principles

• Time-value of money and its mechanics

• Standardized cash flow streams and their

present value formulas

• Effective annual and annual percentage rates

• Loans structured as annuities

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